Modeling a Property Tax Abatement in Real Estate (Updated Jan 2024)
We often field questions about how to model property tax abatements. It’s a concept we cover in our the ‘Advanced Modeling – Property and Portfolio’ endorsement in our Accelerator real estate financial modeling training program and something that has come up several times in our Accelerator Q&A. So, I thought it worthwhile to write a post addressing techniques for modeling property tax abatements in real estate.
Specifically, in this post I show you how to value a property benefited by a property tax abatement as well as how to properly account for the abatement in the residual value of a real estate DCF.
Are you a member of the A.CRE Accelerator? If so, search ‘Abatement’ in the Accelerator Q&A to read the question that spawned this post. If not, become an Accelerator member and master these and other concepts in real estate financial modeling.
What is a Property Tax Abatement
In most cases, the amount of property tax assessed on a property is a function of the value of that property. Low value properties yield low property tax bills, while the inverse is also true. Thus, municipalities have a financial incentive to maximum the value of the real estate within their jurisdiction.
To attract higher value properties, cities will often offer temporary incentives to encourage developers and investors to develop and invest in their city. One such incentive is the Property Tax Abatement.
A Property Tax Abatement is essentially an agreement by the city to charge the property owner less in property tax than the owner would otherwise pay without the abatement. Property Tax Abatements generally have a finite life, offering the owner the benefit for only a specific period of time after which the owner is responsible to pay the full property tax amount.
Issues with Property Tax Abatements in Real Estate Financial Modeling
Whether you’re valuing a property using the direct cap method or calculating the returns using a discounted cash flow model, modeling a property tax abatement presents a few issues.
In the case of a direct cap valuation, modeling the below market property tax amount in the direct cap pro forma results in an overstated valuation. And likewise, in a DCF analysis, modeling the below market property tax amount in the residual pro forma results in overstated return metrics.
Both of these issues arise because of the first rule of direct cap valuation, only cap durable cash flows. The below market property tax amount is non-durable by definition. And thus, by capping a non-durable property tax amount into perpetuity either in the direct cap pro forma or in the residual pro forma leads to inaccurate results.
How to Properly Account for a Property Tax Abatement – Direct Cap Valuation
So how do you properly model a direct cap valuation when the property is subject to a property tax abatement? The process is actually quite simple:
- Set the property tax amount in the direct cap proforma to market, arriving at an adjusted net operating income.
- Calculate the present value of the future property tax abatement payments.
- Cap the adjusted net operating income by the market cap rate to arrive at a market value before accounting for the property tax abatement.
- Add the present value of the property tax abatement to the market value to arrive at an adjusted value inclusive of the property tax abatement.
How to Properly Account for a Property Tax Abatement – DCF Analysis
So how do you properly account for a property tax abatement in your discounted cash flow analysis? Again, the process is actually quite simple:
- Run the discounted cash flow as usual, projecting the actual cash flow inclusive of any property tax abatement payments.
- Adjust the reversion pro forma to include market rate property taxes to arrive at an adjusted reversion net operating income.
- Calculate the present value of the future property tax abatement payments beyond the analysis period.
- Add the present value of the remaining property tax abatement payments to the reversion value to get an adjusted reversion value.
Video Tutorial – Modeling a Property Tax Abatement in Real Estate
To augment the above explanation, I’ve recorded a quick video to show the technique.
While the process for modeling a property tax abatement in real estate is quite simple, failing to properly account for it in your valuation and returns analysis will result in erroneous outcomes. This could lead you to overpay for a particular opportunity. Thus, it’s in mastering these sorts of details that you truly show your value as a real estate professional.
Do you model property tax abatements differently? Have a question about this process? Catch an error I might have missed? Feel free to reach out.
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Version Notes
v1.0
- Initial model launch
